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The Bank-Loan Rush Is Coming

Protection from rising rates won't be cheap once the crowds arrive.

Eric Jacobson, 06/18/2010

We don't usually spend a lot of time trying to figure out which asset classes are going to be popular with investors in the future, but there's one sector for which predicting its ascent is usually easy: floating-rate bank loans.

You wouldn't necessarily assume so based on recent trends. Until May's sovereign debt turbulence pulled some inflation fear out of the market, it had become conventional wisdom that interest rates were headed up soon, a good portent for bank loans. But while bank-loan funds have taken in a healthy chunk of assets--roughly $5.7 billion during this year's first five months--it's a trickle when compared with the massive inflows to the broader income-focused universe of taxable and municipal funds. Combined, those two groups took in nearly $120 billion during the same period, with a big portion of that sum going to core intermediate- and short-term bond funds.

They'll Be Comin' Round The Mountain When They Come
If you look at how investors have behaved in earlier periods, though, the record suggests many more will eventually sprint into bank loans right about the time the Fed begins jacking up short-term interest rates. Based on Chicago Mercantile Exchange data, current market sentiment tips in favor of a Fed funds (the Fed-controlled rate at which banks lend to each other overnight)hike by the end of January, and puts the probability of a hike by the end of April 2011 at roughly 85%.

The appeal behind syndicated floating-rate bank loans, of course, is that their income payouts are almost always tied to LIBOR (which normally moves with the Fed funds rate), and are designed to readjust up or down to its newest level every 90 days. On average then, the duration of a bank-loan portfolio often clocks in at well less than a year, so its price is affected very little by any spike in short-term rates. If those rates are going up, though, a bank-loan portfolio's income stream rises right along with them.

Everything Has a Price
Of course, there's no free lunch. The trade-off for that attractive interest-rate profile and generous income potential is a healthy dose of credit risk. That's because portfolios in this category invest almost exclusively in yield-rich debt that falls under the rubric of highly leveraged loans. (In this case, leverage refers to issuer balance sheets, rather than fund-portfolio leverage.)

Historically, much of this bank-loan debt was incurred as a result of merger and acquisition activity or in the service of capital-intensive business models. Such deals typically involve heavy debt loads, but also the kind of hard-asset security or cash-flow stability that lenders look for to underpin the senior, secured, first-lien structures that dominate this market. There are still plenty of such loans in the marketplace, but much of the issuance in recent years has been the product of large-company, private-equity LBO deals that were in vogue prior to the financial crisis. With the exception of a couple years in the mid 1990s, for example, loans totaling more than $1 billion in size generally didn't exist in this market prior to the late 1990s. They took off thereafter, however, peaked at roughly 50% of the universe during the precrisis boom years, and still comprise more than 40% of the market today according to data from Credit Suisse.

It's also critical to know what kind of fund you're looking at. Bank-loan portfolios come in multiple structures, all the way from exchange-traded closed-end funds, to interval funds that only allow you to request a share tender once per quarter or once per month (like a redemption, but there's no guarantee you'll get all you ask for back at one time), to plain-vanilla open-end mutual funds--and many of them can use portfolio leverage, which is analogous to margin borrowing. That variety is a concession to the fact that loans are not actually securities, and many still don't trade very often or easily (i.e. they can be illiquid). Whereas a leveraged, closed-end bank-loan fund can take on significant issuer size and credit risk, for example, without worrying that redemptions will cause a cash crunch, managers of open-end bank-loan funds typically stick with the largest, most liquid, higher-tier loans and usually keep plenty of cash on hand in case investors come calling for their money.

Is it Safe to go in the Water?
What does all that say about the safety of the bank-loan market? Company size is often considered a positive indicator when it comes to the avoidance of bankruptcy, so there's a case to be made that the universe as a whole has a safer flavor than it once did, particularly now that the financial crisis has passed. Meanwhile, there's a sense among many managers who run bank-loan and high-yield bond portfolios that a diminishing default rate and expectations of a fairly healthy--if sluggish--economy going forward argue that risk is generally dissipating rather than gathering, even given the market's May 2010 volatility.

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